5 - Allocative Efficiency, Externalities, and Government Intervention

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Gustavo Indart

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ALLOCATIVE EFFICIENCY, EXTERNALITIES, AND GOVERNMENT INTERVENTION Productive efficiency: For the firm: requires that the firm be producing its output at the lowest possible cost For the industry: requires that all firms in the industry have the same marginal cost Allocative efficiency: In an individual industry: when the level of output is such that the marginal cost of production equals the market price. In the overall economy: when price equals cost in all industries at once. Consumer and Producer Surplus Consumer surplus: difference between the value that consumers place on a product and the payment they actually make to buy that product (area under the demand curve and above the market price line) Producer surplus: difference between price and marginal cost (area above supply curve and below the market price line) Incidence (or Burden) of a Per Unit Tax Buyers’ Share: difference between the pre-tax and post-tax price paid by Buyers Buyers’ Share (BS) = P - 1 0 Sellers’ Share: difference between the pre-tax and post-tax price received by Sellers Sellers’ Share (SS) = P -0(P -1Tax) The tax revenue collected by the government (or total tax paid) is graphically the area with the tax as the vertical dimension [P - (P - Tax)], which is the difference between the pre-tax and 1 1 the post-tax Supply curves at Q1. The burden of a tax is distributed between consumers and sellers in a manner that depends on the relative elasticities of supply and demand When demand is inelastic relative to supply, consumers bear most of the burden of taxes When supply is inelastic relative to demand, producers bear most of the burden Per Unit Subsidies A subsidy is the opposite of a tax in that the government gives a subsidy per unit rather than takes a tax per unit. We can analyze a subsidy in a similar way, but with a shift down in Supply by the amount of the subsidy rather than the shift up in Supply that occurs with a per unit tax. Maximum Net Social Benefit: P = MC Implies the output where the benefit to society of an additional unit of output equals the cost to society of an additional unit of output. Pareto Efficient Allocation (Pareto Optimality): P = MC The allocation of resources where no person is worse off from trading and any additional trade will make some person worse off Efficiency Loss (Welfare or Deadweight Loss) Measure efficiency loss of an output Qo by the difference between Price and Marginal Cost between the output Qo and optimal output at P = MC. It is the difference between Demand and Marginal Cost between given output and optimal output. This is equivalent to the net loss of consumers’ surplus and producers’ surplus at the output relative to optimal output Competition => Optimum Allocation (Allocation Efficiency, 0 Efficiency Loss) Competitive market equilibrium implies that P = MC, which implies that competitive markets give the optimal allocation of resources Monopoly Regulation Monopolies create efficiency loss by reducing output below competitive output and increasing price above competitive price. Governments attempt to eliminate the efficiency loss caused by a monopoly using two methods: 1) Marginal Cost Pricing (for ‘normal’ monopolies) MC pricing results in 0 efficiency loss but still leaves the monopoly with an economic profit. 2) Average Cost Pricing (for natural monopolies) MC pricing is unattainable for a natural monopoly because there is an economic loss at the output where P = MC. AC pricing is th
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